Buildings, machinery, renovations and computer peripherals are an example of tangible assets that will last your business more than one year of usage. But not indefinitely as they will eventually become obsolete, thus we depreciate these assets’ value over the term of their useful life. For intangible assets such as intellectual property and brands equity, it is called amortization.
Over time, a portion of these assets is being ‘used up’ in the course of your business. This portion is being reported on your Profit and Loss Statement as Depreciation Expense while reducing the value of the assets on your Balance Sheet by the same said amount.
Depreciation and amortization is a non-cash transaction and is being used by businesses for both accounting and tax purposes. Depreciation expense is deductible against the income earned in the same period, thus impacting your bottom line at the end of the fiscal year.
There are a few ways to account for depreciation and amortization. The business can choose the method that best suits their purpose but the assumptions and method must be in line with the accounting framework set out by the country which the business is a resident of.
As a business owner, you must make the call on the following:
- Method and rate of depreciation/amortization
- The useful life of the asset
- Scrap value of the asset
These assumptions once determined, shall be explained clearly in the notes to your financial statements. Any change in accounting treatment subsequently must be fully explained.
Method and Rate of Depreciation/Amortization
There are 2 commonly used methods, namely the straight-line method and the accelerated method.
Straight-Line Method – Taking the original cost of the asset less the scrap value, this result is then divided by the number of useful years of the asset. This method assumes that the depreciation of the asset is equal over the period of its useful life. This is the method that is most commonly used by small businesses.
Accelerated Method – This method provides for more depreciation/amortization in the early life of the assets and lesser in the later years. There are many approaches to this but do note that at the end of it all, the total depreciation/amortization will be the same. It is perhaps with wanting to have greater tax savings earlier that companies will choose to adopt this methodology.
Understanding the impact of depreciation/amortization has on profit and loss statement will enable business owners to have a better grip on their business performance. Earnings and net asset value that are boosted thanks to the choice of depreciation assumptions have nothing to do with improved business performance, and, in turn, don’t signal strong long-term fundamentals.
When in doubt, seek legal advice or consult an experienced ACRA Filing Agent.
The editorial team at Acra Filing Agent
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